Chapter 14 Working Capital Current Asset Management 5 1

Prepared by Instructor: E.Shatha Qamhieh

Course Title: Managerial Finance

An-Najah National University

Short-term financial management:

Management of current assets and current liabilities.

Current assets:

cash, marketable securities, accounts receivable and inventory.

Working Capital Fundamentals

4/16/2012 Managerial Finance-An-Najah university 2

Current liabilities:

(notes payable, accruals, and accounts payable)

Working capital:

Current assets which represent the portion of investment that circulates from

one form to another in the ordinary conduct of business.

Net working Capital:

The difference between the firm’s current assets and its current liabilities, this can be

positive or negative.

If current assets > current liabilities positive net working capital

Net Working Capital


If current Liabilities > current Assets negative net working capital

The greater the margin by which a firm’s current assets cover its liabilities, the

better able it will be to pay its bills as they come due.

The goal of short-term financial management is:

To manage both current assets and current liabilities to achieve a balance between

profitability and risk that contributes positively to the firm’s value.

Trade-off between Profitability and Risk.

Profitability

The relationship between revenues and costs generated by using the firm’s assets—

both current and fixed—in productive activities.

Risk (of insolvency)

The probability that a firm will be unable to pay its bills as they come due.

Technically Insolvent

Describes a firm that is unable to pay its bills as they come due.


Describes a firm that is unable to pay its bills as they come due.

Effects of changing ratios on profits and risk

Cash Conversion Cycle

Cash Conversion Cycle (CCC):

• It is the amount of time a firm’s resources are tied up, calculated by subtracting the

average payment period from the operating cycle.

• It is the length of time required for a company to convert cash invested in its

operations to cash received as a result of its operations.

The cash conversion cycle has three main components:


The cash conversion cycle has three main components:

1. Average Age of Inventory AAI.

2. Average Collection Period ACP.

3. Average Payment Period APP.

CCC = AAI + ACP - APP

CCC = OC - APP

OC = AAI + ACP Operating Cycle (OC):

It is the time measured by number of days

from the beginning of the production process

to the collection of cash from the sale of the

finished product.

Average Age of Inventory (AAI):

It is the average number of days it takes for a firm to sell a product it is currently holding as

inventory to consumers.

Inventory Turnover = Cost of Goods Sold

Average Inventory

Average Age of Inventory = 365 days

Inventory turnover



Average Age of Inventory = Inventory turnover

Average Collection Period (ACP):

It is the average amount of time needed to collect accounts receivable, measured in days.

Average Sales Per Day = Annual Sales

365

Average Collection Period = Accounts Receivable

Average Sales Per Day

Average Payment Period (APP):

It is the average amount of time needed to pay accounts payable, measured in days.

Average Payment Period = Accounts Payable

Average Purchases Per day

Average Purchases Per Day = Annual Purchases

365




Example 1 : Calculate the Operating Cycle (OC) and calculate Cash Conversion

Cycle (CCC) using the following data:

• Annual credit sales = $360,000

• Cost of goods sold = $100,000

• Annual credit purchases = $252,000

• Accounts Receivable = $14,000

• Average Inventory = $10,000

• Accounts Payable = $7,000

• Assume the year has 360 days.

Solving the example:

1) Calculating AAI:

Inventory Turnover = $ 100,000

= 10 times

Inventory Turnover = Cost of Goods Sold

Average Inventory


Inventory Turnover = $ 100,000

= 10 times$ 10,000


= 36 days = AAI10 times


Inventory turnover

Average Sales Per Day = $ 360,000

= $ 1,000360

2) Calculating ACP:

Average Sales Per Day = Annual Sales

360


360

Average Collection Period = $ 14,000

= 14 days = ACP$ 1,000



3) Calculating APP:

Average Purchases Per Day = Annual Credit Purchases

360

Average Purchases Per Day = $ 252,000

= $ 700360


Average Payment Period = Accounts Payable


Average Purchases Per Day = = $ 700360

Average Payment Period = $ 7,000

= 10 days = APP$ 700

4) Calculating OC:

5) Calculating CCC:

OC = AAI + ACP

OC = 36 days + 14 days

OC = 50 days


5) Calculating CCC:

CCC = OC - APP


CCC = 50 days – 10 days

CCC = 40 days

Inventory = Cost of goods sold × AAI

365

= $ Inventory

+ Accounts receivable = Sales × ACP

365= + $ A/R

- Purchases × APP -

Calculating $ resources invested or tied up in the cash

conversion cycle


- Accounts payable = Purchases × APP

365= - $ A/P

Total Resources Invested in the cash conversion cycle = $$$

To reduce the amount of resources tied up in the CCC:

1. Reduce AAI.

2. Reduce ACP.

3. Increase APP.

1) Reducing AAI: reduces resources invested in inventory.

Reduced inventory resources = cost of goods sold × days reduced of AAI

365

2) Reducing ACP: reduces resources invested in accounts receivable.

Reducing the Amount of Resources tied up in the CCC


2) Reducing ACP: reduces resources invested in accounts receivable.

Reduced A/R resources = sales × days reduced of ACP

365

3) Increasing APP: increases resources invested in accounts payable.

Increased A/P resources = purchases × days increased of APP

365

MAX Company has annual sales of $10 million, cost of goods sold of 75% of sales, and

purchases that are 65% of cost of goods sold. MAX has an average age of inventory

(AAI) of 60 days, an average collection period (ACP) of 40 days, and an average

payment period (APP) of 35 days. (Assume the year has 365 days)

Resources Invested in the Cash Conversion Cycle

� Example 2:


1. Calculate the CCC.

2. Calculate cash resources invested or tied up to the cash conversion cycle.

3. How will a5-day reduction in ACP affect the resources invested in the CCC?

1) Calculating CCC:


CCC = 60 + 40 - 35

CCC = 65 days

2) Calculating resources invested or tied up in the cash conversion cycle:

Inventory = Cost of goods sold × AAI

365

= $ Inventory

+ Accounts receivable = Sales × ACP

365

= + $ A/R

- Accounts payable = Purchases × APP

365

= - $ A/P




Inventory = (10,000,000 × .75) × 60

365

= $ 1,232,877

+ Accounts receivable = 10,000,000 × 40

365

= + $ 1,095,890

- Accounts payable = (10,000,000 × .75 × .65) × 35

365= - $ 467,466

Total Resources Invested in the cash conversion cycle = $ 1,861,301

3) Effects of a 5 day reduction in ACP on the resources invested in the CCC :

Reduced A/R resources = sales × days reduced of ACP

365

• This will reduce resources invested in accounts receivable and will reduce resources

invested in the CCC.

Reduced A/R resources = 10,000,000 × 5 days


Reduced A/R resources = 10,000,000 × 5 days

365

Reduced A/R resources = $ 136,986

New amount of resources in CCC after 5-day reduction in ACP is:

= Total resources invested in CCC – resources reduced from A/R

= $ 1,861,301 - $ 136,986 = $ 1,724,315

Strategies for Managing the CCC

1. Turn over inventory as quickly as possible without stock outs that result in lost sales.

2. Collect accounts receivable as quickly as possible without losing sales from high-pressure collection techniques.

3. Manage, mail, processing, and clearing time to reduce them


3. Manage, mail, processing, and clearing time to reduce them when collecting from customers and to increase them when paying to suppliers.

4. Pay accounts payable as slowly as possible without damaging the firm’s credit rating.

Managing the first component of the CCC

Inventory Management:

� The objective of managing inventory is to Turn over inventory

as quickly as possible without stock outs that result in lost

sales.

� Classification of inventories:


� Classification of inventories:

1. Raw materials: items purchased for use in the manufacturing

of a finished product.

2. Work-in-progress: all items that are currently in production

but are not finished.

3. Finished goods: all items that have been produced and finished

but not yet sold.

Differing Views About Inventory� The different departments within the firm (finance, production, marketing, etc.) often have

different views about what is an “appropriate” level of inventory.

� Financial managers:

• Do not have direct control over inventory, instead they provide input to the inventory management process.

• They would like to keep inventory levels low to ensure that funds are not being unwisely invested in excess resources.

� Marketing managers:


� Marketing managers:

• They would like to keep finished goods inventory levels high to ensure orders could be

quickly filled, eliminating the need for backorders due to stock outs.

� Manufacturing managers:

• They would like to keep raw materials levels high to avoid production delays and to make larger, more economical production runs that will result in finished goods of acceptable quality at a lower unit cost.

� Purchasing managers :

• They are concerned with raw material inventory only, and would like to purchase large quantities of raw material than actually needed to get quantity discounts with favorable prices.

Techniques for Managing Inventory1) The ABC Inventory System:

� It is an inventory management technique that divides inventory into three groups - A, B,

and C, in descending order of importance and level of monitoring, on the basis of the dollar

amount invested in each.

� A typical system would contain:

1. Group A would consist of 20% of the items worth 80% of the total dollar value.

2. Group B would consist of the next largest investment.


3. Group C would consist of the largest amount but lowest price items.

� Control of the A items would be intensive because of the high dollar investment involved.

A group items are tracked on a perpetual inventory system that allows daily verification of

each item’s inventory level.

� B group items are frequently controlled through periodic, perhaps weekly, checking of their

levels.

� Control of the C items would be low because of the low dollar investment involved. C

group items are monitored with unsophisticated techniques, such as the two-bin method.

2) The two-bin inventory method:

� It is an unsophisticated inventory monitoring technique that is typically applied to

C group items and involves reordering inventory when one of two bins is empty.


• With the two-bin method, the item is stored in two bins. As an item is

needed, inventory is removed from the first bin. When that bin is empty, an

order is placed to refill the first bin while inventory is drawn from the second

bin. The second bin is used until empty, and so on.

• The large dollar investment in A and B group items suggests the need for a

better method of inventory management than the ABC system. The EOQ model,

discussed next, is an appropriate model for the management of A and B group

items.

Economic Order Quantity (EOQ) Model

Economic order quantity (EOQ) model

Inventory management technique for determining an item’s optimal order size, which

is the size that minimizes the total of its order costs and carrying costs.

Order costs

The fixed clerical costs of placing and receiving an inventory order.

Carrying costs


Carrying costs

The variable costs per unit of holding an item in inventory for a specific period of

time.

Total cost of inventory

The sum of order costs and carrying costs of inventory.

C

O) S 2( ××=EOQ

) Q S ( O ÷×=CostOrder

) 2 Q ( C ÷×=CostCarrying

] 2) Q ( C [ ] ) Q S ( O [ ÷×+÷×=CostTotal

Cost Carrying t Order cosCostTotal +=

C

O) S 2( ××== EOQQ

EOQ minimizes the total cost of both order costs and carrying costs.

To minimizes the total cost


] 2) Q ( C [ ] ) Q S ( O [ ÷×+÷×=CostTotal

periodunits per usage in S =

riodnit per pecost per u carrying C =

nitsntity in u order quaQ =

rt per orde order cosO =

To minimizes the total cost

of both order costs and

carrying costs, we use EOQ

to substitute for Q in the

provided total cost, order

cost and carrying cost

equations.

Carrying costs (Variable costs) include:

• Storage costs

• Insurance costs

• Deterioration costs

• Obsolescence costs

• Opportunity costs

Order costs (Fixed costs) include:


Order costs (Fixed costs) include:

• Cost of writing a purchase order.

• Cost of processing resulting paperwork

• Cost of receiving an order.

• Cost of checking order against invoice.

If the size of the order increase the result will be:

• a decrease in order costs.

• an increase in carrying costs.

Assume that RLB, Inc., a manufacturer of electronic test equipment, uses

1,600 units of an item annually. Its order cost is $50 per order, and the

carrying cost is $1 per unit per year.

1) Calculate EOQ.

2) Calculate minimum total cost.

Example 3 :


2) Calculate minimum total cost.

C

O) S 2( ××== EOQQ

cost totalminimize that Q unit 400 $1

$50) 1,600 2(==

××== EOQQ

Solution: 1) Calculating EOQ

Ordering Costs = $50 x (1600 / 400 ) = $50 x 4 = $200

Solution: 2) Calculating minimum total cost:

) Q S ( O ÷×=CostOrder


Carrying Costs = $1 x (400 / 2) = $1 x 200 = $200

Total Costs = $200 + $200 = $400

) 2 Q ( C ÷×=CostCarrying

Cost Carrying t Order cosCostTotal +=

� The Reorder Point and Safty stock:

� Once a company has calculated its EOQ, it must determine when it should place its orders.

� The reorder point: is the point at which the firm must reorder inventory.

� Lead Time: is the time measured by number of days that the firm needs to place and receive an order.


Reorder point = (lead time in days x daily usage) + Safety stock

Daily usage = Annual usage / Work or operating days per year

needs to place and receive an order.

� The safety stock: is extra inventory that is held to prevent stock outs of important items.

� If we assume that inventory is used at a constant rate throughout the year (no seasonality), the reorder point can be determined by using the following equation:

Daily usage = 1,600 / 360 = 4.44 units/day

If a company requires 10 days to place and receive an order, and the annual

usage is 1,600 units per year. The company operates 360 days per year.

Calculate the reorder point.

� Example 4 :

Daily usage = Annual usage / operating days per year


Reorder point = (10 x 4.44) + 0 = 44.44 or ~ 45 units

Thus, when inventory level reaches 45 units, the company should place an

order for 400 units. However, if the company wishes to maintain a safety

stock to protect against stock outs, they should order before inventory level

reaches 45 units.


� Example 5 : A company has the following data:

• Usage in units per year = 10,000 unit.

• Order cost per order = $100

• Carrying cost per unit per year = $2

• Lead time = 5 days.

• Safety stock = 10 units.

• The company operates 250 days per year.

1.Calculate the Economic Order Quantity (EOQ)


C

O) S 2( ××== EOQQ unit 1,000

$2

$100) 10,000 2(=

××=1)

1.Calculate the Economic Order Quantity (EOQ)

2.Calculate the Economic Reorder Point

2)


Daily usage = Annual usage / Work or operating days per year

Daily usage = 10,000 / 250 = 40 unit

Reorder point = (5 x 40) + 10 = 210 units.

� The firm’s goal for inventory is to turn it over as quickly

as possible without stock outs.

� Inventory turnover is best calculated by dividing cost of

goods sold by average inventory.

� The importance of EOQ model is the following:

1. It determines the optimal order size and minimizes total


1. It determines the optimal order size and minimizes total

costs.

2. It determines indirectly, through the assumption of

constant usage, the average inventory.

3. Thus the EOQ model determines the firm’s optimal

inventory turnover rate, given the firm’s specific costs of

inventory.

Managing the second component of the CCC

Accounts Receivable Management:

� The second component of the cash conversion cycle is the average collection period (ACP).

� Average collection period: is the average length of time from a sale on credit until the payment becomes usable funds to the firm.


credit until the payment becomes usable funds to the firm.

� The collection period consists of two parts:

1. The time period from the sale until the customer mails payment: this involves managing the credit available to the firm customers.

2. The time from when the payment is mailed until the firm collects funds in its bank account: this involves collecting and processing payments.

� The objective for managing accounts receivable is to collect

accounts receivable as quickly as possible without losing sales from

high-pressure collection techniques.

� Accomplishing this goal includes three topics:

(1) credit selection and standards.

(2) credit terms.

(3) credit monitoring.



� Credit selection process:

1. involves application of techniques for determining which customers

should receive credit.

2. involves evaluating the customer’s creditworthiness and comparing it

to the firm’s credit standards.

� Credit Standards: they are the firm’s minimum requirements for

extending credit to a customer.


The Five Cs of Credit:Five C’s of credit:

The five key dimensions—character, capacity, capital, collateral, and

conditions— used by credit analysts to provide a framework for in-depth credit

analysis.

� Because of the time and expense involved, this credit selection method is

used for large-dollar credit requests.

� Analysis via the five C’s of credit does not yield a specific accept/reject


1. Character: The applicant’s record of meeting past obligations.

2. Capacity: The applicant’s ability to repay the requested credit.

3. Capital: The applicant’s debt relative to equity.

4. Collateral: The applicant amount of assets available for use in securing the credit.

5. Conditions: Current general and industry-specific economic conditions

� Analysis via the five C’s of credit does not yield a specific accept/reject

decision, so its use requires an analyst experienced in reviewing and granting

credit requests.

credit scoring :

A credit selection method commonly used with high volume/ small dollar

credit requests; relies on a credit score determined by applying

statistically derived weights to a credit applicant’s scores on key financial

and credit characteristics.

Credit Scoring:


� Simply stated, the procedure results in a score that measures the

applicant’s overall credit strength, and the score is used to make the

accept/reject decision for granting the applicant credit.

� The purpose of credit scoring is to make a relatively informed credit

decision quickly and inexpensively, recognizing that the cost of a single

bad scoring decision is small.

Credit Scoring of a customer by Haller's Stores

Financial and credit characteristics

Score

(0 to 100)

(1)

Predetermi

ned weight

(2)

Weighted

score

[(1) x (2)]

(3)

Credit references 80 .15 12.00

Example on credit scoring:


Credit references 80 .15 12.00

Home ownership 100 .15 15.00

Income range 70 .25 17.50

Payment history 75 .25 18.75

Years at address 90 .10 9.00

Years on job 80 .10 8.00

Total 1.00 Credit score 80.25

Accounts Receivable Management

Changing the Credit Standards

� The firm sometimes will make changing its credit standards to improve its returns and generate greater value for its owners.


• If credit standards were tightened (shortening of credit

standards), the opposite effects would be expected.

Effects of a Relaxation of Credit Standards

� The company needs to determine whether to relax its credit standards or not based on the effect of this relaxation.

� The firm must compare between the marginal return and marginal cost for credit relaxation.


Change in profit

contribution from sales

Added costs from

marginal investment in

accounts receivable

marginal cost of bad

debts

Marginal Return Marginal Costs

Compare

� Decision rule:

� Relaxing the credit standards:

� If additional profit contribution from sales > marginal costs, then credit standards should be relaxed.

• Shortening the credit standards:� If the reduction in profit contribution from sales < marginal costs

savings, then credit standards should be shortened.


additional profit


added costs of the


accounts receivable

marginal cost of bad

debts


>The company should relax its credit standards.

First : Calculating Marginal Return:

Additional profit contribution from sales

change in sales units unit contribution margin×=


(sales units with relaxation – sales units without relaxation)

(Price per unit – Variable cost per unit)

Second : Calculating Marginal Costs :

(1) Calculating costs of marginal investment in accounts receivable:

urnoverceivable TAccount Re

able CostTotal VariReceivableAccountsinInvestmentAverage =

in unitsles volume annual sanit cost per u Variable able Cost Total Vari ×=

365

Turnover eceivableAccounts R =


Average investment in accounts receivable with relaxation

Average investment in accounts receivable without relaxation

Marginal investment in accounts receivable

Required return on investment (opportunity cost rate)

Cost of marginal investment in accounts receivable

-=×=

)eriod (ACPllection PAverage Co

365 Turnover eceivableAccounts R =

(2) Calculating costs of marginal bad debt :

Cost of bad debt with relaxation (Under proposed plan)

Cost of bad debt without relaxation (Under present plan)

Costs of marginal bad debt=-

salesdollar annual debt bad of % Debt Bad of Cost ×=

Third : Calculating Net Profit or Loss From the Implementation of the Proposed Plan (with credit relaxation):


Proposed Plan (with credit relaxation):

Change (addition) in profit contribution from sales

Costs of marginal investment in accounts receivable

Costs of marginal bad debt

Net profit or loss from making credit relaxation (proposed plan) =

--

Change (reduction) in profit contribution from sales

Cost savings from marginal investment in accounts receivable

Cost savings from marginal bad debt

Net profit or loss from making credit relaxation (proposed plan) =

++

Relaxing

of credit

standards

Shortening

of credit

standards

A firm is currently selling a product for $10 per unit. Sales (all on

credit) for last year were 60,000 units. The variable cost per unit is

$6. The firm’s total fixed costs are $120,000. The firm is currently

considering a relaxation of credit standards that is expected to result

in the following:

1. a 5% increase in unit sales to 63,000 units.

� Example 6 : making a decision to provide credit relaxation or not.


1. a 5% increase in unit sales to 63,000 units.

2. an increase in the average collection period from 30 days (the

current level) to 45 days.

3. an increase in bad-debt expenses from 1% of sales (the current

level) to 2%.

4. The firm determines that its cost of tying up funds in receivables

is 15% before taxes.


A firm is considering making a relaxation of credit standards, using the following

information:

With credit relaxation ( proposed plan ) Without credit relaxation ( present policy )

ACP 60 days ACP 40 days

Annual units’ sales 100,000 unit Annual units’ sales 80,000 unit

Price per unit $30 per unit Price per unit $30 per unit

� Example 7 :


Price per unit $30 per unit Price per unit $30 per unit

Variable cost per unit $21 per unit Variable cost per unit $21 per unit

Bad debt expenses 10% Bad debt expenses 5%

• Opportunity Cost ( Required Rate of Return ) is 10%

• Assume the year has 360 days.

1.Calculate the change in Profit contribution from sales:

2. Calculate Marginal Investment in Accounts Receivable (A/R):

A/R With credit relaxation ( proposed plan ) A/R Without credit relaxation (present policy )

= change in sales units unit contribution margin×= (100,000 – 80,000) ( 30 – 21 ) = 20,000 × 9 = $ 180,000 addition ×

Cost Variable Total Cost Variable Total


Marginal Investment in Accounts Receivable = $ 350,000 - $ 186,667 = $ 163,333 addition

3. Calculate (Opportunity cost) or Cost of Marginal Investment in Accounts Receivable:

Turnover ReceivableAccount

Cost Variable Total =

60 / 360

100,000 21

×

=

6

2,100,000 = 350,000 $ =



40 / 360

80,000 21

×

=

9

1,680,000 = 186,667 $ 186,666.7 $ ≅=

16,333.3 $ .10 163,333 $ =×=cost y Opportunit receivable accountsin investment Marginal ×

16,333 $≅ addition

4. Calculate Cost of Marginal Bad Debt:

Bad Debt With credit relaxation(proposed plan ) Bad Debt Without credit relaxation (present policy )


100,000 $30 .1 d Debt Cost of Ba ××=

$ 300,000d Debt Cost of Ba =


80,000 $30 .05 d Debt Cost of Ba ××=



Cost of Marginal Bad Debt = $ 300,000 - $ 120,000 = $ 180,000 addition

5. Do you advice the company to make credit relaxation? Yes or No / Why?

Additional profit contribution from sales $ 180,000

Costs of marginal investment in accounts receivable (16,333)

Costs of marginal bad debt (180,000)

Net profit or loss from making credit relaxation (proposed plan) $ (16,333)=

--

No, credit standards should not be relaxed because the additional profit contribution from sales < marginal costs, which results in net loss.

� P14 –12: Shortening the credit period

A firm is contemplating shortening its credit period from 40 to 30 days and

believes that, as a result of this change, its average collection period will

decline from 45 to 36 days.

Bad-debt expenses are expected to decrease from 1.5% to 1% of sales. The

firm is currently selling 12,000 units but believes that as a result of the

proposed change, sales will decline to 10,000 units.


proposed change, sales will decline to 10,000 units.

The sale price per unit is $56, and the variable cost per unit is $45. The firm

has a required return on equal-risk investments of 25%.

Evaluate this decision, and make a recommendation to the firm.

(Note: Assume a 360-day year.)



A/R With credit shortening ( proposed plan ) A/R Without credit shortening (present policy )

= change in sales units unit contribution margin×= [10,000 – 12,000] [56 – 45] = - 2,000 × 11 = ( $ 22,000 ) reduction ×



Marginal Investment in Accounts Receivable = $ 45,000 - $ 67,500 = ( $ 22,500 ) savings

3. Calculate (Opportunity cost) or Return on Marginal Investment in Accounts Receivable:



36 / 360

unit 10,000 $45

×

=

10

450,000 $ = 45,000 $ =



45 / 360

unit 12,000 $45

×

=

8

$540,000 = 67,500 $ =

5,625) ($ .25 22,500) ($ =×=

return Required receivable accountsin investment marginal reduced from Benefits ×=

savings

4. Calculate Cost of Marginal Bad Debt:

Bad Debt With credit shortening (proposed plan ) Bad Debt Without credit shortening (present policy )


nits 10,000 u $56 .01 d Debt Cost of Ba ××=

600,5 $ d Debt Cost of Ba =


12,000 $56 .015 d Debt Cost of Ba ××=



Cost of Marginal Bad Debt = $ 5,600 - $ 10,080 = ($ 4,480) savings

5. Do you advice the company to make credit shortening? Yes or No / Why?

Reduction in profit contribution from sales ( $ 22,000)

Benefits or savings from reduced marginal investment in accounts receivable 5,625

Savings in costs of marginal bad debt 4,480

Net profit or loss from making credit shortening (proposed plan) ($ 11,895)=

+

No, credit shortening should not be done, because the reduction in profit contribution from sales < savings in marginal costs, which results in net loss.

+

Credit TermsCredit Terms

The terms of sale for customers who have been extended credit by the

firm.

� Terms of net 30 mean the customer has 30 days from the beginning of

the credit period (typically end of month or date of invoice) to pay the

full invoice amount.


full invoice amount.

Cash Discount

A percentage deduction from the purchase price; available to the credit

customer who pays its account within a specified time.

� For example, terms of 2/10 net 30 mean the customer can take a 2

percent discount from the invoice amount if the payment is made within

10 days of the beginning of the credit period or can pay the full amount

of the invoice within 30 days.

� A firm’s business strongly influences its regular credit terms. For example, a

firm selling perishable items will have very short credit terms because its

items have little long-term collateral value; a firm in a seasonal business may

tailor its terms to fit the industry cycles.

� A firm wants its regular credit terms to conform to its industry’s standards. If

its terms are more restrictive than its competitors’, it will lose business; if its

terms are less restrictive than its competitors’, it will attract poor-quality


terms are less restrictive than its competitors’, it will attract poor-quality

customers that probably could not pay under the standard industry terms.

� The bottom line is that a firm should compete on the basis of quality and

price of its product and service offerings, not its credit terms. Accordingly,

the firm’s regular credit terms should match the industry standards, but

individual customer terms should reflect the riskiness of the customer.

1. Including a cash discount in the credit terms is a popular way to speed up

collections of accounts receivable without putting pressure on customers.

2. The cash discount provides an incentive for customers to pay sooner.

3. By speeding collections, the discount decreases the firm’s investment in

accounts receivable, but it also decreases the per-unit profit. Additionally,

initiating a cash discount should reduce bad debts because customers will pay

Characteristics of providing a cash discount:


initiating a cash discount should reduce bad debts because customers will pay

sooner, and it should increase sales volume because customers who take the

discount pay a lower price for the product.

4. Accordingly, firms that consider offering a cash discount must perform a

benefit–cost analysis to determine whether extending a cash discount is

profitable.

Effects of a providing a cash discount

� The company needs to determine whether to provide a cash discount or not based on the effect of this discount.

� The firm must compare between the marginal return and marginal cost for cash discount.


Change in profit


Cost savings from the


accounts receivable

Cost of cash discount


Compare

� Decision rule:

� Providing Cash discount to customers:

� If additional profit contribution from sales and cost savings from account receivable > cost of cash discount, then cash discount should be provided.

� If additional profit contribution from sales and cost savings from account receivable < cost of cash discount, then cash discount should not be provided.


additional profit

contribution from sales Cost of cash discount


>The company should provide a cash discount.

not be provided.

Cost savings from the


accounts receivable

First : Calculating Marginal Return:


change in sales units unit contribution margin×=


(sales units with cash discount – sales units without cash discount)

(Price per unit – Variable cost per unit)

Second : Calculating Marginal Costs :

(1) Calculating cost savings from reduced investments in accounts receivable:

urnoverceivable TAccount Re

able CostTotal VariReceivableAccountsinInvestmentAverage =

in unitsles volume annual sanit cost per u Variable able Cost Total Vari ×=

365

Turnover eceivable Accounts R =


Average investment in accounts receivable with cash discount

Average investment in accounts receivable without cash discount

Reduction in accounts receivable investment

Required return on investment (opportunity cost rate)

Cost savings from reduced investments in accounts receivable

-=×=

)eriod (ACPllection PAverage Co

365 Turnover eceivable Accounts R =

(2) Calculating the cost of cash discount:

unit per price

discount cash withunits in sales

discount cash take whocustomers %

discount cash of % Discount Cash of Cost

×

×

×

=

Third : Calculating Net Profit or Loss From the Implementation of the Proposed Plan (with cash discount):


Proposed Plan (with cash discount):


Cost savings from reduced investments in accounts receivable

Cost of cash discount

Net profit or loss from providing cash discount (proposed plan) =

+-

1. A company has annual sales of $10 million and is considering initiating a

cash discount by changing its credit terms from net 30 to 2/10 net 30.

2. The firm has an average collection period ACP of 40 days and expects this

change to result in an average collection period ACP of 25 days.

3. The company has current annual usage of 1,100 units at a variable cost of

$2,300 per unit and sells for $3,000 on terms of net 30.

4. The company estimates that the discount will increase sales of the finished

� Example 8 : making a decision to provide cash discount or not


4. The company estimates that the discount will increase sales of the finished

product by 50 units (from 1,100 to 1,150 units) per year.

5. The company estimates that 80% of its customers will take the 2% discount

6. The company estimates that the cash discount will not alter its bad debt

percentage.

7. Opportunity cost of funds invested in accounts receivable is 14%.

Should the company offer the proposed cash discount?


No the company should not offer the cash discount because this will provide net loss.

1. A company currently makes all sales on credit and offers no cash

discount.

2. The firm is considering offering a 2% cash discount for payment

within 15 days.

3. The firm’s current average collection period is 60 days, sales are

40,000 units, selling price is $45 per unit, and variable cost per unit

is $36.

� P14 –11: Initiating a cash discount


is $36.

4. The firm expects that the change in credit terms will result in an

increase in sales to 42,000 units, that 70% of the sales will take the

discount, and that the average collection period will fall to 30 days.

If the firm’s required rate of return on equal-risk investments is 25%,

5. should the proposed discount be offered?

(Note: Assume a 360-day year.)



A/R With cash discount ( proposed plan ) A/R Without cash discount (present policy )

= change in sales units unit contribution margin×= (42,000 – 40,000) ( 45 – 36 ) = 2,000 × 9 = $ 18,000 addition ×



Marginal Investment in Accounts Receivable = $ 126,000 - $ 240,000 = ($ 114,000) reduction

3. Calculate (Opportunity cost) or Return on Marginal Investment in Accounts Receivable:



30 / 360

unit 42,000 $36

×

=

12

$1,512,000 = 126,000 $ =



60 / 360

40,000 36 $

×

=

6

1,440,000 = 240,000 $ =

28,500) ($ .25 114,000) ($ =×=

return) (Requiredcost y Opportunit receivable accountsin investment Marginal ×=

savings

4. Calculate Cost of cash discount:

Cost of cash discount (proposed plan )

unit per price

discount cash withunits in sales

discount cash take whocustomers %

discount cash of % Discount Cash of Cost

×

×

×

=

nits 42,000 u

$45

.7

.02

×

×

×

=


Cost of cash discount (proposed plan ) = $26,460

5. Do you advice the company to provide a cash discount? Yes or No / Why?

Additional profit contribution from sales $ 18,000

Cost savings from reduced investment in accounts receivable 28,500

Cost of cash discount (26,460)

Net profit or loss from making credit relaxation (proposed plan) $ 20,040=

+-

Yes, cash discount should be provided because the additional profit contribution from sales and savings from accounts receivable > marginal costs of cash discount, which results in net profit.

It is the number of days after the beginning of the credit period during which the

cash discount is available.

� The financial manager can change the cash discount period, but the net effect

of changes in this period is difficult to analyze because of the nature of the

forces involved.

� The following changes would be expected to occur:

(1) Sales would increase, positively affecting profit.

Cash Discount Period


(1) Sales would increase, positively affecting profit.

(2) Bad-debt expenses would decrease, positively affecting profit.

(3) The profit per unit would decrease as a result of more people taking the

discount, negatively affecting profit.

(4) The investment in account receivable will decrease because of non–discount

takers now paying earlier. However, the investment in accounts receivable

will increase for two reasons:

1. Discount takers will still get the discount but will pay later.

2. New customers will be attracted by the new policy which will result in

new accounts receivable.

Credit MonitoringIt is the ongoing review of a firm’s accounts receivable to determine

whether customers are paying according to the stated credit terms.

� Slow payments are costly to a firm because they lengthen the average

collection period and thus increase the firm’s investment in accounts

receivable.

� Two frequently used techniques for credit monitoring are:

1. Average collection period ACP.

2. Aging of accounts receivable.


2. Aging of accounts receivable.

(1) ACP average collection period:

It is the average number of days that credit sales are outstanding.

� The average collection period has two components:

1. the time from sale until the customer places the payment in the mail.

2. the time to receive, process, and collect the payment once it has been

mailed by the customer.



(2) Aging of Accounts Receivable

Aging schedule:

It is a credit-monitoring technique that breaks down accounts receivable into groups on the

basis of their time of origin; The breakdown is typically made on a month-by-month basis,

going back 3 or 4 months, it indicates the percentages of the total accounts receivable

balance that have been outstanding for specified periods of time.

Example 10 :


The accounts receivable balance of a firm on December 31, 2012, was $200,000. The firm

extends net 30-day credit terms to its customers. The firm had the following aging schedule.

Example 10 :

� Reviewing the aging schedule, we see that 40% of the accounts are current (age 30

days) and the remaining 60% are overdue (age 30 days). Eighteen percent of the

balance outstanding is 1–30 days overdue, 26% is 31–60 days overdue, 13% is 61–

90 days overdue, and 3% is more than 90 days overdue.

� There is a high percentage of the balance outstanding that is 31–60 days overdue

(ages of 61–90 days). Clearly, a problem must have occurred 61–90 days ago.


� Investigation may find that:

1. The problem can be attributed to the hiring of a new credit manager.

2. The problem can be attributed to the acceptance of a new account that made a

large credit purchase but has not yet paid for it.

3. The problem can be attributed to the ineffective collection policy.

� When this problem is found in the aging schedule, the analyst should determine,

evaluate, and remedy its cause.

Credit Monitoring: Collection Policy

� The firm’s collection policy is its procedures for collecting

a firm’s accounts receivable when they are due.

� The effectiveness of this policy can be partly evaluated by

evaluating at the level of bad expenses.

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evaluating at the level of bad expenses.

� As seen in the previous examples, this level depends not

only on collection policy but also on the firm’s credit

policy.

Collection Policy

Table 14.4 Popular Collection Techniques

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Management of Receipts & Disbursements: Float

� Collection float is the delay between the time when a payer deducts a payment from its checking account ledger and the time when the payee actually receives the funds in spendable form.

Disbursement float is the delay between the time when a

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� Disbursement float is the delay between the time when a payer deducts a payment from its checking account ledger and the time when the funds are actually withdrawn from the account.

� Both the collection and disbursement float have three separate components.

�Mail float is the delay between the time when a payer places payment in the mail and the time when it is received by the payee.

� Processing float is the delay between the receipt of a

Management of Receipts & Disbursements: Float

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� Processing float is the delay between the receipt of a check by the payee and the deposit of it in the firm’s account.

� Clearing float is the delay between the deposit of a check by the payee and the actual availability of the funds which results from the time required for a check to clear in the banking system.

Management of Receipts & Disbursements: Speeding Up

Collections

� Lockboxes

� A lockbox system is a collection procedure in which payers send

their payments to a nearby post office box that is emptied by the

firm’s bank several times a day.

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firm’s bank several times a day.

� It is different from and superior to concentration banking in that

the firm’s bank actually services the lockbox which reduces the

processing float.

� A lockbox system reduces the collection float by shortening the

processing float as well as the mail and clearing float.

Management of Receipts & Disbursements: Slowing Down

Payments

� Controlled Disbursing

� Controlled Disbursing involves the strategic use of mailing

points and bank accounts to lengthen the mail float and clearing

float respectively.

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float respectively.

� This approach should be used carefully, however, because longer

payment periods may strain supplier relations.

Management of Receipts & Disbursements: Cash

Concentration

� Direct Sends and Other Techniques

� Wire transfers is a telecommunications bookkeeping device that removes funds from the payer’s bank and deposits them into the payees bank—thereby reducing collections float.

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� Automated clearinghouse (ACH) debits are pre-authorized electronic withdrawals from the payer’s account that are transferred to the payee’s account via a settlement among banks by the automated clearinghouse.

� ACHs clear in one day, thereby reducing mail, processing, and clearing float.

Management of Receipts & Disbursements:

Zero-Balance Accounts

� Zero-balance accounts (ZBAs) are disbursement accounts that always have an end-of-day balance of zero.

� The purpose is to eliminate non-earning cash balances in corporate checking accounts.

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The purpose is to eliminate non-earning cash balances in corporate checking accounts.

� A ZBA works well as a disbursement account under a cash concentration system.

Investing in Marketable Securities

Table 14.5 Features and Recent Yields on Popular Marketable

Securities a (cont.)

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Investing in Marketable Securities (cont.)


Securities a (cont.)

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Investing in Marketable Securities (cont.)


Securities a

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Chapter 14 Working Capital Current Asset Management 5 1

Documents

positively affecting profit

additional profit contribution

cash conversion cycle

4 16 2012 managerial finance

accounts receivable opportunit

accounts receivablemanagerial finance

economic order quantity

reduces resources invested